Having the right balance between your debt and your income level should be a key factor in achieving financial freedom. Falling deeper into unmanageable debt is very easy as there are very lucrative offers from an array of creditors. It is therefore imperative to stay vigilant on your income and debt appetite. Continually servicing your existing loans is also advised as they lessen the burden that may arise from fines and changes in interest rates.
So, what is the debt-to-income ratio?
Simply put DTI ratio is your monthly debt obligations in relation to your income before taxes and other deductions, gross income. DTI is one of the ratios that lenders and creditors use to understand your ability to pay back any borrowed money, credit worthiness. It may therefore affect how much a lender is willing to lend to you and also the interest rate they will use.
A low DTI ratio shows that the borrower has maintained the right balance between their income and debt. So, a low percentage is deemed better while a high percentage demonstrates that the borrower is servicing a lot of loans on a monthly basis. Financial creditors and banks will opt to give loans to persons with a low DTI compared to those with a high one as it shows that the borrower is efficient in repaying their loans.
To qualify for a mortgage the highest accepted DTI is 43%. Most lenders will opt for a borrower with a debt-to-income ratio of 36% and below with less than 28% servicing a mortgage or used to pay rent. It is therefore imperative to keep an eye on your loan appetite and make sure that the DTI ratio is as low as possible as this will improve your chances of having your loans approved or getting a high probability for consideration.
How to Calculate Your Debt-to-Income Ratio
As this is one of the ratios that can aid you in knowing if you will be considered for a loan, it is important to calculate it regularly. Here is how to simply do the calculation:
Monthly Debt Repayments/ x 100
Monthly Gross Income
Let’s give a real-life example:
Susan has approached her bank for a loan to expand her Boutique business in Manhattan. Before she visits her bank, she has decided to calculate her DTI ratio to see if her loan request will be honoured. Here are her Finances:
• Student loans – $600
• Mortgage – $1200
• Truck loan – $360
• Gross Income- $9,000
Therefore, the total monthly debt is:
$600+ $1200 + $360 = $2,160
To get the DTI ratio $2,160/ $9000 x 100 = 24%
Susan may decide to lower her DTI ratio to improve her chances of securing a loan. One can lower the DTI ratio by reducing the monthly recurring debt or increasing their monthly gross income.
Going by the above example, Susan may reduce paying her truck loan to $300 hence this giving a lower DTI ratio:
$600 + 1200 + 300 = $2,100
Therefore:
$2100/ $9,000 x 100 = 23.3%
Alternatively, she may increase her Gross Income to 10,000:
Hence:
$2160/$10,000 x 100 = 21.6%
You can easily access the DTI ratio calculator by clicking this link from Wells Fargo which is one of the most active lenders in the United States https://www.wellsfargo.com/goals-credit/debt-to-income-calculator/.
USDA Loans
People from eligible rural areas or investors in such areas are the only ones qualified for these types of loans to either buy or refinance their homes. It is mandatory to have a DTI not exceeding 41%. A borrower also has to satisfy these requirements:
1. Your household income has to be less than 115% of the median income in your area.
2. The lender MUST consider the income of everybody in your household, that is consider all the occupants living under the same roof even those that are not servicing any loans.
So as to know if your DTI qualifies for a USDA loan, your lender will only consider the income and the debts of those on loans. While the income of the other occupants not on loan will only be used in determining if your household meets the required income threshold, and hence won’t be used in calculating the DTI.
Limitations of Debt-to-Income Ratio
Most financial ratios cannot be used on their own and have to be used alongside other ratios so as to get the right picture of your debt status. DTI ratio has some limitations:
• The ratio doesn’t consider the difference in types of loans and the cost associated with paying off that debt. An example is student loans will basically have a lower interest rate compared to loans from credit cards.
• It doesn’t consider people that transfer balances from cards with high interest to those with a low-interest rate. This in the real sense, can decrease your monthly payments hence decreasing your DTI ratio but your debt remains unchanged.
CONCLUSION
Maintaining a low debt-to-income ratio is highly advisable for everyone as it increases their chances of securing another loan. Paying off your debt in time or having a financial advisor to help you identify the lenders with the lowest interest rates will come in handy in ensuring that you have a low DTI.
Timing is also very important as one can know if they are in a position to take up another loan or first finish financing an existing debt. You may opt to wait for the best time to take up a loan so as to keep your DTI low. Cutting your expenditure and using that extra money to pay off debts can also come in handy in finishing paying off existing debts.
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Contributor: Francis Kimani
